Download Classical Macroeconomics

The Theory of Aggregate Demand
Classical Model
Learning Objectives
• Understand the role of money in the classical
model.
• Learn the relationship between the quantity theory
and the Cambridge equation.
• Learn how to derive and shift the classical
aggregate demand curve.
• Understand how the equilibrium price level and
equilibrium GDP are determined.
• Understand the four policy implications of the
classical model.
Aggregate Demand
• Aggregate demand is the total demand in an
economy for all the goods and services
produced.
• The aggregate demand schedule is a
schedule relating the total demand in an
economy for all the goods and services to
the price level.
• Aggregate demand with aggregate supply
determines the price level.
Aggregate Demand Curve
• The aggregate demand curve slopes down.
– As the general price level rises, the amount of
goods and services that are produced decreases.
• How can we better understand this concept?
– Economic theory.
Money Demand
• Money yields a flow of exchange services
that increase the convenience of buying and
selling goods and services.
– Marginal benefit of holding money is the
usefulness of having ready cash.
– Marginal cost of holding money is the
opportunity cost associated with not buying
goods and services.
Budget Constraint: Barter Economy
• PYD = Pp
+
wLS
– where
• PYD = Demand for Commodities
• Pp = Profit
• wLS = Labor Income
• In this economy, no money changes hands
and no family uses money for trade, but
money can be used as a unit of account.
Budget Constraint: Monetary
Economy
• MD + PYD = p + wLS + MS
– where
•
•
•
•
•
MD =
PYD =
p =
wLS =
MS =
Money Held at the End of the Period
Demand for Commodities
Profit
Labor Income
Money Supply at the Beginning of the
Period
Budget Constraint: Classical Model
• MD + PYD = p + wLS + MS
– MS acts like additional income that is available to buy
commodities.
– MD represents the money people do not spend during
the period. It is the amount they set aside for future
purchases.
– The decision to hold money idle imposes an
opportunity cost on people equal to the additional utility
that could be gained by purchasing commodities.
Money Demand: Classical Model
• Classical economists argued that the stock
of money that the average household needs
at any moment in time is directly
proportional to the dollar value of its
demand for commodities.
– MD
=
k
x
PYD
• where k is the factor of proportionality.
The Cambridge Equation
• MD = kPYD is a demand for money theory
known as the Cambridge equation.
– Money demand is some fraction (k) of total
nominal output.
• Money demand is determined only by income.
– People hold this money in anticipation of the
exchanges they will make in the near future.
– They allocate the rest of their income to
immediate consumption of goods and services.
Aggregate Demand: Classical Model
•
•
•
•
•
•
MD = kPYD
MD = MS
kPYD = MS
Solve for P
MS /k
= PYD
MS /kYD
=P
Equilibrium Condition
Divide both sides by k
Divide both sides by YD
Aggregate Demand
• P = MS/(kYD)
– The equation shows how the price level is related
to GDP, when money demand just equals money
supply.
• Note the inverse relationship between Y and P.
– Along any single aggregate demand curve, money
supply is constant.
– Classical economists also assumed that k was a
constant, determined by institutional factors.
The Quantity Theory of Money
• The quantity theory relates the price level to the
quantity of money circulating in an economy.
• According to the Equation of Exchange,
– MV = PY
• Money supply times its velocity equals nominal GDP.
– MD = MS
• Money demand equals money supply at equilibrium.
– MD = (1/V)PY = MD = kPY
• Money demand is proportional to nominal GDP.
– P = (MS1/k)/Y = MS/kYD
• Aggregate demand curve at equilibrium.
Irving Fisher and Velocity
• V =
PT/MS
– The velocity of circulation just equals the average
value of transactions divided by the nominal money
supply.
• T = YD
• V = PYD/MS
• P = VMS/YD
– Since V = 1/k, Fisher’s version of the relationship
between the price level and GDP is identical to that of
the Cambridge equation and the quantity theory.
Aggregate Demand Curve
At every point on the AD curve, the demand
for money just equals money supply.
P
P2
In addition, the nominal value of GDP (PxY)
is constant. Classical economists also assumed
that k was a constant.
The aggregate demand curve slopes downward
because as the price level falls people have more
money on hand to buy goods and services.
P1
AD
0 Y
1
Y2
Y
Equilibrium
P
AS
The equilibrium price level
ensures that the amount of real
output that individuals wish to
purchase, given the quantity of
money and the income velocity of
money, is equal to the level of
real output produced by firms.
AD
0
Y
Shifting Aggregate Demand
• Two factors shift aggregate demand
– Changes in the money supply
• Increases shift AD to the right.
• Decreases shift AD to the left.
– Changes in k
• Decreases in k shift the AD to the right.
• Increases in k shift the AD to the left.
Aggregate Demand
P
Shifts in aggregate demand are caused
by changes in the money supply or changes
in the velocity of money.
An increase in money or a decrease in k
shifts AD to the right.
A decrease in money or an increase in k
shifts AD to the left.
0
Y
AD3
AD2
AD1
Aggregate Demand and Aggregate
Supply: Math
• Previous results:
YS
1 – LD
LS
(w/P)E
LE
YE
=
=
=
=
=
=
LD – (½ )(LD)2 Production function
(w/P)
Labor demand
(w/P)
Labor supply
½
Equilibrium real wage
½
Equilibrium labor
3/8
Equilibrium output
Aggregate Demand and Aggregate
Supply: Math
•
•
•
•
•
Let k = 2 and MS = 100.
P = MS/kYE
P = 100/2 x (3/8) = 133.33
(w/P)E = ½
wE
= PE x ½ = 66.66
Implications of the Classical
AD/AS Model
• There are four implications that can be drawn
from the long-run aggregate demand/aggregate
supply model.
– Full employment prevails: Recessions and
booms must be temporary.
– Changes in aggregate demand have no impact
on output and employment.
– Inflation is a monetary phenomenon.
– Supply is the key to growth.
Full Employment Prevails
• The classical model is characterized by the
process of market clearing.
– Surpluses and shortages are short run,
transitory events that are corrected by price
changes that re-equilibrate the relevant
markets.
• Recessions and booms are temporary and
self-correcting.
Full Employment Prevails
AS
P
If the price level is P3, excess
supply of goods and services
drives down prices until
equilibrium is reached.
P3
If the price level is P1, excess
demand for goods and services
drives up prices until
equilibrium is reached.
.
P2
P1
0
AD
Y1
Y2
Y3
Y
Changes in Aggregate Demand Have
No Effect on Output or Employment
• Shifts in aggregate demand change the price
level, but cannot change the level of output.
– An increase in aggregate demand causes the
price level to rise. Prices rise until the original
equilibrium level of Y is restored.
– A decrease in aggregate demand causes the
price level to fall. Prices fall until the original
equilibrium level of Y is restored.
Aggregate Demand and
Employment
P
AS
P2
B
P1
A
An increase in aggregate demand causes
the aggregate demand curve to shift to
the right. At C, demand exceeds supply
causing the price level to rise.
C
AD2
0
Y1
AD1
Y
Y=F(L)
Y
Y
Y1
L
0
w/P
0
P
Y
Y1
LS
1
W/P1
W/P2
3
P2
P1
2
AD2
AD1
LD
0
LS
LD
L
0
Y1
Y
Aggregate Demand
• Increases in the aggregate demand curve cause
prices to begin to rise.
– As P rises, the real wage falls, encouraging firms to
hire more workers.
– But, the decrease in the real wage also causes
workers to decrease labor supply.
– The nominal wage, w, rises until labor demand just
equals labor supply.
– Output remains constant. In equilibrium, only the
price level increases.
Policy Implication
• Macroeconomic stabilization policies are
powerless.
– Government spending and/or taxing policies
typically are designed to shift aggregate
demand rather than aggregate supply and so
are powerless to change economic conditions
in the classical model.
– Why?
Inflation is Caused by the Central
Bank
• Inflation is a sustained rise in the overall price
level.
– In the classical model, the price level rises
when AD shifts to the right .
– Given constant velocity, aggregate demand
shifts only when the money supply changes.
– Therefore, the central bank causes inflation
with excessive monetary growth.
Money, Output, and Inflation
P
AS
P2
B
P1
A
An increase in the money supply causes
the aggregate demand curve to shift to
the right. At C, demand exceeds supply
causing the price level to rise.
C
AD2
0
Y1
AD1
Y
Y=F(L)
Y
Y
Y1
0
W
L 0
P
Y1
P2
3
Y
LS
6
W/P1
W/P2
5
4
P1
2
1
AD2
AD1
LD
0
LD
LS
L
0
Y1
Y
Money and Inflation
• Inflation is a monetary phenomenon.
– Aggregate demand shifts to the right as the money
supply rises. Prices begin to rise.
– As P rises, the real wage falls, encouraging firms to
hire more workers.
– But, the decrease in the real wage causes workers to
decrease labor supply.
– The nominal wage, w, rises until labor demand just
equals labor supply.
– Output remains constant. In equilibrium, only the
price level increases.
Inflation and the Quantity Theory
• MSV = PYS
• /\MS/MS + /\V/V = /\P/P + /\YS/YS
• /\P/P = /\MS/MS – /\YS/YS
– The rate of inflation equals the rate of money
supply growth minus the rate of output
growth.
Policy Implication
• Money does not influence real events in the
classical model.
– A change in the money supply shifts aggregate
demand.
– This begins a process of market clearing that
ultimately results in the restoration of equilibrium
at the initial level of Y coupled with a new price
level.
• Money is a veil = Money neutrality
Supply is the Key to Growth
• Aggregate supply increases for two reasons:
– New technology increases the productivity of
each worker.
– A higher real wage increases the number of
laborers in the labor supply.
Supply is the Key to Growth
P
AS1
AS2
Economic growth causes the aggregate
supply curve to shift to the right.
At every price level, more is produced.
P1
Note that, other things remaining the same,
an increase in aggregate supply results in a
decrease in the price level
A
B
P2
AD
0
Y1
Y2
Y
Y
Y2=F(L)
Y2
Y
2
Y1=F(L)
Y1
1
L 0
P
0
w/P
Y
AS1
AS2
LS
w2/P1
w1/P1
2
1
AD
0
LD1 LD2
L1
L
0
Y1
Y2
Y
Productivity Increase
• New technology, more capital and better trained
workers increase productivity.
– The production function shifts up.
– The labor demand curve shifts to the right.
• The increase in demand for labor increases the real
wage, causing an increase in labor supply along
the labor supply curve.
• Aggregate supply increases.
– At the price level, P1, more output is produced.
Y=F(L)
Y
Y
Y2
Y1
L 0
P
0
w/P
Y1
Y
LS1
LS2
w1/P1
w2/P1
1
2
AD
LD
0
L1 L2
L 0
Y1 Y2
Y
Increase in Labor Supply
• A change in worker preferences with respect to
labor supply and an increase in the number of
workers available shift the labor supply curve.
– If workers decide to work more or the labor force
expands, the labor supply curve shifts to the right.
– The increase in labor supply decreases the real wage,
causing firms to move down along the labor demand
curve and hire more workers.
– Equilibrium employment and aggregate supply
increase.
Policy Implication
• Government policies designed to influence
economic activity should be carefully
examined for their impact on labor demand
and labor supply.
– Tax changes can either increase or decrease
labor supply.
– Tax changes can either increase or decrease
business incentives to invest in new capital.
Y=F(L)
Y
Y
Y1
0
w/P
L
L1
0
Y
P
LS
w/P
LD
0
L1
L 0
Y
Y=F(L)
Y
Y
Y1
L
0
w/P
0
P
Y
Y1
LS
w/P1
P1
AD1
LD
0
L1
L
0
Y1
Y